Chapter 6
The Goals of Macroeconomic Policy
When men are employed, they are best contented.
BENJAMIN FRANKLIN
Inflation is repudiation.
CALVIN COOLIDGE
Goals of Macroeconomic Policy
• Economic growth – ingredients
– Aggregate supply (Chapter 7 and 10)
– Aggregate demand (Chapter 8 and 9)
2
Goals of Macroeconomic Policy
• Macroeconomics policy
– Growth policy (target: long-run growth)
• Make economy grow faster in long-run
– Stabilization policy (target: short-run
business cycles)
• Manage aggregate demand
• Avoid high unemployment
• Avoid high inflation
3
Goals of Macroeconomic Policy
• Achieving rapid growth while keeping
both unemployment and inflation low
1. The Goal of Economic Growth
• Economic growth
– Increasing standard of living
• Roman Empire to Industrial Revolution
– Little economic growth
• Per-capita income
– Decreased
» Former Soviet Union
» Poorest African countries
• U.S. standard of living
– Increased – factor of 8 since 1900
5
Productivity Growth: From Little Acorns…
• Small differences in growth rates
– Enormous difference – long run
• 109 years; 1870 – 1979
– Compound annual growth
• U.S. – 2.3%
• U.K. – 1.8%
• Japan – 3%
6
Productivity Growth: From Little Acorns…
• Labor productivity
– Amount of output
– One worker produces
• In an hour (or a week, or a year) of labor
– Output = GDP
• Labor productivity = GDP per hour of work
7
Productivity Growth
• Productivity growth
– Almost everything in long run
• Rising productivity
– Raising standard of living – long run
• Long periods of time
– Small differences
• Rates of productivity growth
• Compound over time
– Enormous difference to society’s prosperity
8
Productivity Growth
• Productivity growth
– Reduction of poverty
– Increases in leisure time
– Increases in country’s ability to finance
• Education
• Public health
• Environmental improvement
• Arts
9
Potential GDP & Production Function
• Potential GDP
– Real GDP
– Economy would produce
– Labor & other resources - fully employed
• Labor force
– Number of people
– Holding or seeking jobs
10
Potential GDP & Production Function
• Estimate potential GDP
– Available inputs
• Produce output
– Available technology
• Production function
– Volume of output produced
– Given inputs
– Given available technology
11
Figure 1
M
K
Y1
Real GDP
Real GDP
The economy’s production function
B
K0
Y1
A
A
Y0
Y0
0
K1
L0
Labor input
(hours)
(a) Effect of better technology
0
L0
Labor input
(hours)
(b) Effect of more capital
12
Potential GDP & Production Function
• Along production function: depends on
labor input
– Holding constant
• Capital
• Technology
• Production function – shifts upward
– Improved technology
– More capital
13
Growth Rate of Potential GDP
• Growth rate of potential GDP
– Depends on
• Growth rate of labor force
• Growth rate of capital stock
• Rate of technical progress
• GDP = Hours of work ˣ Output per hour
= Hours of work ˣ Labor productivity
14
Growth Rate of Potential GDP
• Growth rate of potential GDP =
= Growth rate of labor input +
+ Growth rate of labor productivity
• Capital is incorporated into labor
productivity
• 1995-2007 actual GDP growth rate =
3.1%
– Growth rate of labor input = 1%
– Growth rate of labor productivity = 2.1%
15
Table 1
Recent growth rates of real GDP in the united states
Years
Growth Rate
per Year
1995-1997
1997-1999
1999-2001
2001-2003
2003-2005
2005-2007
1995-2007
4.1%
4.3
2.2
2.1
3.4
2.5
3.1
16
Actual vs Potential GDP
• Growth rates: Actual & Potential GDP
– Over long periods of time
• Similar
– Over short periods of time
• Diverge sharply
• Cyclical fluctuations
Figure 2
Actual and potential GDP in United States since 1954
18
2. The Goal of Low Unemployment
• Unemployment rate
– Number of unemployed people / labor
force
• If actual GDP grows slower than potential
– Unemployment rate – rises
• If actual GDP grows faster than potential
– Unemployment rate – falls
19
Table 2
The economic costs of high unemployment
Year
Civilian
Unemployment
Rate
Capacity
Utilization
Rate
Real GDP Lost
Due to Idle
Resources
1958
1961
1975
1982
1992
2003
6.8%
6.7
8.5
9.7
7.5
6.0
75%
77.3
73.4
71.3
79.4
73.4
4.8%
4.1
5.4
8.1
2.6
2.2
20
Human Costs of High Unemployment
• Unemployment rates
– Lower
• Married men
• Whites
• Well-educated people
– Higher
• Teenagers
• Nonwhites
• Blue-collar workers
21
Human Costs of High Unemployment
• Human costs of unemployment
– Income loss
– Hunger, cold, ill health
– Psychological cost
– Unemployment insurance
– Social welfare programs
22
Figure 3
Unemployment rates for selected groups, 2007
23
Counting the Unemployed
BLS Category:
• Employed
– People currently working
• Full time or part time
• Unemployed
– People not currently working
• Temporarily laid-off, expected to return
• Actively looking for a job (4 weeks)
• Not in labor force (discouraged workers)
– Not looking for work
• When they quit, unemployment rate ↓
24
Counting the Unemployed
• Hidden / disguised unemployment
– Involuntary part-time
– Loss of overtime
– Shortened work hours
– Discouraged workers
– Not included in official unemployment
statistics
25
Types of Unemployment
• Frictional unemployment
• Normal turnover in labor market
• Temporarily between jobs
– Moving / changing occupations
• Structural unemployment
• Displaced by automation
• Skills - no longer in demand (US textile and
manufacturing industries)
• Cyclical unemployment
• Decline in economy’s total production
• Rises during recessions
26
Full Employment
• Full employment
– Everyone willing & able to work can find a
job
– Only frictional and structural unemployment
exist
– “Full Employment” = zero cyclical
unemployment  zero unemployment
– 4-6%
27
Unemployment Insurance
• Unemployment insurance
– Government program
– Replaces some wages lost (average
weekly benefit check is $288 in 2007)
• Eligible workers who lose their jobs
• Benefits of UI
– Cushion to unemployed, prop up
aggregate demand during recession
– “built-in stabilization”
28
Unemployment Insurance
• Payroll taxes & Unemployment benefits
– Spread cost of unemployment
– Doesn’t eliminate basic economic cost
• Higher unemployment benefits
– Disincentive to look for job
– Unemployment rate even higher
29
3. The Goal of Low Inflation
• Purchasing power
– Of a given sum of money
– Volume of goods & services
• Real wage rate
– Purchasing power of wages
– Wage rate – adjusted for inflation
– Nominal wage divided by price index
30
Figure 4
Rates of change of wages and prices in the United
States since 1948
31
Inflation: Myth and Reality
• Myth: inflation erodes real wages
Reason for Nominal Wages to
Increase
Amount
Higher productivity
Compensation for higher prices
2%
3%
Total
5%
• Wage rate tends to rise with inflation, so
real wage rate is not systematically
eroded by inflation.
32
Inflation: Myth and Reality
• Inflation
– Increase in “average price”
• Relative price of item
– In terms of price of other item
• Inflation
– Not to blame
– Some goods become more expensive
• Relative to others
33
Table 3
Pure inflation
Item
Candy bar
Movie ticket
Automobile
Last Year’s Price
This Year’s Price
Increase
$0.50
6.00
9,000
$0.55
6.60
9,900
10%
10
10
34
Table 4
Real-world inflation
Item
Candy bar
Movie ticket
Automobile
Last Year’s Price
This Year’s Price
Increase
$0.50
6.00
9,000
$0.50
7.50
9,450
0%
25
5
35
Inflation: Redistribution of Income & Wealth
• Redistribution caused by inflation
– Harm: lenders
– Gain: borrowers
– Inflation does not systematically steal
from the rich to the poor, nor the reverse
36
Real vs. Nominal Interest Rates
• Expected inflation
• Unexpected inflation
• Real rate of interest
– Percentage increase in purchasing power
• Borrower pays to lender
• For borrowing
– Lenders
• Increased ability - purchase goods & services
37
Real vs. Nominal Interest Rates
• Nominal rate of interest
– Percentage
• Borrower – pays back
• Exceeds money borrowed
– No adjustment for decline in purchasing
power
• From inflation
38
Real vs. Nominal Interest Rates
• Nominal interest rate =
Real interest rate + Expected inflation rate
• If inflation accurately predicted
– No income redistribution
– Expected rate of inflation = Actual rate of
inflation
39
Real vs. Nominal Interest Rates
• Example: John wants to borrow $1000
from Nancy. Both agreed real interest
rate = 3%
• If both expect inflation = 6%, nominal
interest rate = 9%
• If actual inflation is 2%, Nancy gains.
Her real interest rate = 7%
• If actual inflation is 8%, John gains. He
only pays real interest rate = 1%
Inflation Distorts Measurements
• Confusing real and nominal interest rates
– Nominal 12% in 1980 (inflation 10%) vs.
6.5% in 2006 (inflation 2.5%)
• Malfunctioning tax system
– Taxes on nominal interest and nominal
capital gain
– During high inflation era, although capital
gain is positive, real capital gain might be
negative
– Discourage saving and investment
• Real interest rate matters
41
Other Costs of Inflation
• Rapidly changing prices
– Riskier to enter long-term contracts
– Economic stagnation
– Shop around more, increases searching
costs
42
Costs of Low vs. High Inflation
• Steady inflation
– More predictable
• Than variable inflation
– Smaller social & economic costs
• Average level of inflation
– Steady inflation at 6% per year
• More damaging than
• Steady inflation at 3% per year
• Hyperinflation
43
Costs of Low vs. High Inflation
• Low inflation
– Doesn’t necessarily lead to high inflation
• Inflation
– Sometimes speeds up
– Sometimes slows down
• Runaway inflations
– When government prints incredible
amounts of money
• Finance wartime expenditure
44
Summary
• Dual task for macroeconomics
– Growth policy on AS side
– Stabilization (demand-management)
policy on AD side
• Economic growth = productivity growth
• Unemployment rate: measurement and
three types
• Cost of inflation
APPENDIX
How statisticians measure inflation
• Index number
– Cost of market basket of goods
• Relative to its cost in “base” period
Cost of market basket
in given year
CPI in given year 
 100
Cost of market basket
in base year
46
APPENDIX
Index numbers for inflation
• Index number problem
– Changing relative prices
– No “perfect price index”
• Correct for every consumer
– Statistical index
• Understate increase in cost of living
– Some families
• Overstate increase in cost of living
– Other families
– Index - “average” family
47
APPENDIX
Consumer price index
• Consumer price index (CPI)
– Bureau of Labor Statistics (BLS)
– Monthly
– Representative
• Typical urban household budget
– Same bundle of goods & services
48
Table 5
Results of Student Expenditure Survey, 1983
Item
Hamburger
Jeans
Movie ticket
Total
Average
Price
Average Quantity
Purchased per Month
Average Expenditure
per Month
$0.80
24.00
5.00
70
1
4
$56
24
20
$100
49
Table 6
Prices in 2007
Item
Hamburger
Jeans
Movie ticket
Total
Price
Increase over 1983
$1.20
30.00
7.00
50%
25
40
50
Table 7
Cost of 1983 student budget in 2007 prices
70 Hamburgers at $1.20
1 pair of jeans at $30
4 movie tickets at $7
Total
$84
30
28
$142
51
APPENDIX
Using price index: ”deflate” monetary figures
Real spending Nominal spending in 2007

 100
Price index of 2007
in 2007
• Deflating
– Process - find real value
• Some monetary magnitude
– Divide by some appropriate price index
52
APPENDIX
Using a price index to measure inflation
• Inflation
– Rate of increase in price level
– CPI2006 = 201.6
– CPI2007 = 207.3
– CPI2007 / CPI2006 = 207.3/201.6 = 1.028
– Inflation = 2.8%
53
APPENDIX
GDP deflator
• GDP deflator
– Price index
– Used to deflate nominal GDP
– Broad measure of economy-wide inflation
• Includes prices
– All goods & services in economy
Nominal GDP
Real GDP 
 100
GDP deflator
54